Volatility Hedge Optimization

HPI10alpha Program (TaP©)

Over the Hedge: Volatility Hedge Optimization

Improve your equity trading performance using proven performance management techniques

revised: 15 May 2019


Following on from the Volatility Hedge article, we explore some optimizations that have value under differing market conditions.

Establish the Hedge Parameters

Our first step is to decide how to construct the hedge. There are a multitude of scenarios to consider so we will enumerate a few and focus on what we consider the current state of the market.

As noted in the our 'Volatility Hedge' article, not all markets require hedging. Different from your home, it is both possible and clever to choose when to hold insurance and when to not do so.

Here are some market types to consider.

Papa Bear Market
  • Very strong resistance level at current prices, potentially multiple attempts to break through them with clear rejection of the attempts. Market threats appear well known with one or more manifesting putting significant pressure on the market. The bulls are fatigued while the bears are fresh and ready to take down the market. Strong support levels are not nearby

It is too late for a hedge at this point. Instead, closing positions followed by closing the hedge is the action of the day.

Mama Bear Market
  • Sideways trend with a fairly defined range. Market threats appear well known with medium probabilities of occurrence holding the market in check. Market players are fitful, making up stories to explain the lack of action. Strong resistance and support levels are not nearby.This is the 'Mama Bear' scenario as Mama Bear worries and wrings her hands as the market moves slightly in either direction without conviction.

This may be a reasonable place to consider 'topping up' a hedge depending on your market perspective. The cost will still be relatively low: this is different from attempting to buy insurance in the face of an incoming hurricane, this is the calm before a potential storm.

Baby Bear Market
  • Strong directional Bull trend, relatively late in the cycle with the appearance of fading (trend slope declining). Market threats appear well known with medium probabilities of occurrence; however, Bulls are getting fatigued and significant resistance levels are close. This is the 'Baby Bear' scenario where the Bear family is out on their walk and Baby Bear is getting tired and cranky. Without some catalyst, e.g., honey or porridge, the market may take the turn.

Potentially a market condition for reassessing the hedge position as costs will remain relatively low for more insurance.

Goldilocks Market
  • Strong bullish directional trend, neither early or late in the trend. Market threats appear well known with medium to low probabilities of occurrence. Bulls are fresh and resistance levels are not nearby. Everything is just right.

Throughout this phase, little or no market hedging is required. We may look at Sector or individual Equity protection, but not a portfolio scale hedge.

Bull Market
  • Strong directional trend, early in the trend. Market threats appear well known with low probabilities of occurrence. One or more threats appear to be diminishing in potential to wreak havoc. Bulls are fresh and eager with support levels nearby and plenty of room to resistance.

Given the early nature of the turn to a bull condition, retaining some hedge may be prudent.

Often, it is these inflection points that present significant opportunity: catching downturns early enables quick action to preserve capital; catching reversals quickly enables larger upside capture.

Example Scenario

We will take a run through the Baby Bear scenario to consider some optionality on constructing it and managing it. This is what the current market looks like for us: with a few threat reductions the market could take off; without them, it could easily turn over.

For us, this is the trickiest of the scenarios and the one most fraught with risk. Over insuring is nearly as impactful to our portfolio as under insuring.

We will use the S&P 500 index. Were we hedging a Sector or a given Equity, choosing something other than a Market Index would certainly make sense.

Here, we do want a Market related index. The S&P is Market Capitalization Weighted, which may or may not be best. The DOW is equity price weighted, in our thinking the worst of the indexes out there. Take a look at our article comparing the various indices you might use. We will explore other possibilities in future articles on risk management and benchmarking.

HPI has worked through some significant market history to establish a proprietary relationship between moves in the S&P 500(SPX) and VXXB. We use this simply to establish where we want to place our VXXB hedge given our forward view of the SPX.

With this knowledge, we can choose an optimal VXXB spread given our desired insurance point, whether that is a 5%, 10% or 15% drop in the SPX.

This information is built in to our toolset, the Trader Performance Coach© (TPC™).

Our requirements are:

  • Allow a 10% market correction; this is our risk tolerance;
  • Take action at the -10% level to hedge a further 5% loss;
  • Total portfolio is $500k; ex-cash: $375k

Your mileage may vary and our Volatility Hedging Tool©, built into the TPC will guide you in calculating the appropriate VXXB levels.

SPX Correction Drives VXXB Choices

As of this date, -10% SPX correlates to a VXXB value of 39.5; -15% SPX correlates to a VXXB value of 46.

Looking through the Volatility Hedging Tool output, possibilities range from leverage of 10.6-31.2 and hedge costs range from $906-$2,693.

Things are never as simple as the government approach of taking the lowest cost.
VXXB Evaluation

Looking at the VXXB from a technical trader's perspective, we can note some levels of resistance and support that will help inform our decision on the appropriate hedge.

Evaluating 1 Oct 2018 to present while honoring deeper history we can see price action on the round trip of the latest significant market correction.

We would like to choose our VXXB spread in such a way that it costs as little as possible yet actually has some reasonable probability of landing in the money should a significant correction occur.

  • Setting up our spread above 50 will likely end in cost without value.
  • Setting our spread below 32 will likely end with high cost and a small payout.
  • Something that hits maximum value above 40 looks to be a nicely balanced position.

Combining this with the output from the Volatility Hedge Tool, the sweet spot appears to be somewhere between a 40/41 and 40/46 call spread on VXXB.

Select the VXXB Spread

Our Volatility Hedge Tool demonstrates that we could spend from $906 to $2,551 on these spreads. The leverage ranges from 31x to 10x in leverage across that range.

There is no correct answer. If our market view indicates the market may more likely continue to grind higher, moving to 3,000-3,200 on the SPX, take the lower cost approach.

With a market view that we really are approaching a significant roll-over; that the threats like tariff resolution, North Korea political issues, the political elite continuing to be stupid, the EU getting aggressive on counter-tariffs, etc., perhaps spending a bit more may make sense.

This is the 'it depends' part of the program.

So, that would be the hedge we would put on.

To evaluate the merit of the approach, we will take a quick look at a back-test.


Our TPC tool uses Black-Scholes to calculate theoretical future option prices; for back-testing we will use ThinkBack on the TradeStation platform.

The last time VXXB was in this area was about 17 Sep 2018 so we will use that as the day we decided to take the volatility hedge.

A major challenge in back-testing is controlling our cognitive biases. As we can see additional forward data, a natural Confirmation Bias may creep into our choices.

We might have waited until about 24 Sep for the Nov monthly strikes; we might have taken the Nov 2 weekly strikes at 45 days; or, we might have gone out to the Dec 21 monthly strikes at 95 days.

As we like to go out 60-90 days, we'll choose the Dec 21 strikes. There is no wrong answer here. Weeklies can sometimes suffer from lack of liquidity; shorter time to expiration can be less expensive but require more renewals.

Using our process rules:

  • Lowest BUY strike;
  • Largest leverage;
  • Smallest spread;
  • Lowest spread cost

We use the Volatility Hedge Tool and have choices of 41/42 spread (15.2x@$1,846); 43/44 (15.2x@$1,846); 43/46 (15.2x@$1,501) and a few others at higher strikes.

As we would be looking at this on 17 Sep 2018, VXXB $40 and $46 would have appeared as significant resistance. We would likely have chosen the 41/42 Dec 21 call spread to stay near the $40 resistance level. The 43/46 is a bit cheaper and if VXXB were not so low, we might have gone for lower cost insurance.

Our portfolio was roughly $500k with 25% in cash. Our goal would have been to insure 5% of $375k or ~$20k.

The Volatility Hedge Tool indicates we could insure that amount with 263 contracts at a total cost of $1,846 including our commissions.

Here is our plan vs. the outcome:

  • No action on 10% loss: portfolio loses 9.3% on $375k or -$34,875;
  • Close positions to cash ASAP and close hedge: hedge brings in net +$7,890 while preventing a further 5% drop of $18,750;
  • Hedge cost was $1,846 or about 0.5% of invested portfolio, $375k.

It is interesting to note that the value of the hedge drops to $3,945 on 30 Oct, one day later. That will certainly not always be the case but does underscore the need to follow the process: close your positions, then close the hedge for what you can get.

It is equally interesting to note that had we held the hedge until 20 December, some 3 weeks later, we would have pulled in $35,505 on the hedge rather than the $7,890.

There is nothing that precludes us from taking a new and separate bearish position that nearly mirrors the hedge. However, that happens after protecting the portfolio by following the hedging process.

Never, ever convert a hedge to a trade. On the map of investing, there be dragons there.


There are a variety of ways to skin a cat (none of which are enjoyed by the cat). This is one tool you might use for hedging at a portfolio/market level.

  • Insure only the invested portion of the portfolio;
  • Choose the base level of risk that you are willing to accept; whether that is 5%, 10% or more, it is not wrong as it is your tolerance level;
  • Choose how much insurance you are willing to buy above your base; this is really a measure of how fast you can act to close positions and move to cash;
  • Given the base level of risk, establish your 'point of no return', that level in the current market where you will pull the trigger on the hedge process irrespective of any other influences: no whining, wishing, hoping ...;
  • Close your positions as quickly as you can; when complete, immediately close the hedge.

Nothing prevents us from taking new positions to take advantage of a falling market: protect your capital first.

"Markets are never wrong – opinions often are" Jesse Livermore